Cyprus: capital controls imposed to prevent crisis spreading to the rest of eurozone

Capital controls on cash and bank transactions in Cyprus are aimed at stopping
the collapse of its financial sector but could become a reality throughout
Europe if there is contagion to the wider eurozone.

Protesters take part in an anti-bailout rally outside the parliament in Nicosia 2013Photo: Reuters

Banks on the Mediterranean island will stay closed into next week as the government in Cyprus, Russia and the European Union haggle over who is pick up the bill from a failed banking sector.

In reality capital controls have been imposed since last Friday as a “bank holiday” that has stopped savers carrying out electronic transfers in order to prevent a run on Cypriot banks.

The break has been extended after the eurozone proposed hitting depositors at the weekend, a proposal rejected in the Cypriot parliament on Tuesday leading to new doubts over the future of banks in Cyprus.

The proposal to tax all savers between 6.75pc and 9.9pc made capital controls, preventing people from moving their money, a necessity to stop depositors moving their cash out of Cypriot banks, pushing the island’s financial sector into a cataclysmic collapse.

It is worth remembering that a run on banks in Cyprus could wipe out the savings of 60,000 Britons, including at least 12,000 pensioners, if the financial sector collapses.

The EU’s much vaunted “deposit guarantee scheme”, promising savers that cash up to €100,000 is safeguarded, is not worth the paper that it is written on if the Cyprus state is bankrupt.

Without a eurozone bailout when banks open next Tuesday that is what will happen as the European Central Bank cuts off, as already threatened, “emergency liquidity assistance” to the Ctypriot Laika Bank causing its collapse and a simultaneous failure of the island’s largest bank, the Bank of Cyprus.

If that happens the entire banking and financial sector in Cyprus falls over and the state is bankrupt, facing an insolvency bill that would go much higher than the €17bn it is seeking from outside lenders, the eurozone and Russia, to secure itself.

There might be one euro but there is not one backstop for depositors, despite calls for a banking union including eurozone-wide deposit insurance. If a country’s financial institutions go bankrupt and a nation state is unable to pick up the bill then savers lose their money.

Capital controls might hit the average saver and ordinary members of the public hardest but they are cheaper and politically easier than asking German or other EU taxpayers to underwrite Cypriot bank deposits, even if they do belong to a British pensioner.

Restrictions including limits on cash-machine withdrawals, are also legal under Article 65 of Europe's internal market rules allowing the emergency measures to preserve “public policy and security”.

This means that even when banks in Cyprus open next Tuesday there will be tight controls to stop British savers, or anyone else, moving their cash out of a banking sector that has lost all credibility and where deposits have already been threatened.

The nightmare scenario is contagious bank run, if the Cyprus banking crisis spreads like wildfire to Spain and Italy as savers take fright and move their cash to safe havens in Northern Europe. In that scenario capital controls become widespread triggering a new credit crunch and pushing a fragile eurozone to collapse.